The bridge finance facility is misused
in a number of cases, especially when projects are financed on political rather
than real business considerations. A measure drawback is that the new
entrepreneurs - or those who are not serious with the implementation of the
project - avoid going for the IPO as they fear massive under-subscription and
could hardly manage an underwriter. Strangely enough, the SBP regulations
allowed the bridge finance to be treated as part of the equity. This is highly
anomalous and heavily loaded in favour of the non-serious sponsors. It simply
means that a project required to have a debt limit of 60 percent is allowed to
operate with 80 percent debt burden and that too for a number of years.

The sponsors of most of the politically
financed projects took advantage of this lacuna and abandoned the project
through default after making quick buck. Their 20 percent equity investment
normally came through low-cost agricultural land documented as high-price
industrial land. The kickbacks from the suppliers of imported machinery were the
icing on the cake.

The financial section of the project
basically revolved around the financial assumptions the corporate finance
mangers were required to develop. In fact these assumptions used to be already
there in the feasibility submitted by the corporate client, but the corporate
bankers put these assumptions to serious scrutiny and in the process the
assumptions got changed drastically. The major assumptions related to company's
sales projections, product unit cost and product unit price.

Other assumptions include: number of
labor and supervisors, office staff, sales and marketing staff, executives etc.
required for the project and the corresponding wages, salaries and
remunerations. The accuracy of the major assumptions depends on the work carried
out on the marketing side. Stern verification of company's claim for the market
share of its product is necessary as major variance in the volume of sales could
jeopardize the very viability of the project.

Intense market survey is also required
to be taken by the corporate banker to ascertain the price level that the
company product is likely to attain. The components of product cost should also
be put under the scanner. The sustained and easy availability of raw material,
utilities and labour is to be ensured both under the existing and future
conditions. A project requiring imported raw material needs special attention of
corporate bankers as frequent changes in global conditions and government import
policy could render the project inoperable.

The norm is to draw financial
projections for the first 5 to 10 years of the project operations. The projected
financial accounts that usually need to be drawn are: balance sheet, income
statement and cash flow statement. Computer-based programs for drawing these
statements are immensely helpful these days. Prior to computerization of banking
and financial systems, these statements had to be drawn manually with the help
of a calculator alone. It used to be a hell of a job for the corporate bankers
then. Computer-based calculations are of great help for financial sensitivity
analyses. These analyses check the project profitability under changing
conditions, for example change in the volume of sales, price cuts, cost
escalations, imposition of new taxes or withdrawal of certain monetary
incentives as a result of change in the government policy. These analyses should
be carried out pragmatically to check the elasticity of the project rather than
to scare away the sponsors by showing them a horrible future scenario under
changing conditions. The guiding principle should be the law of probability that
decrees that all bad things should not happen together.

A negative change might well be offset
by a simultaneous change for the better. Nevertheless, the sensitivity analysis
is a good tool to detect vulnerable points of the project and the findings
should be discussed with the sponsors who might come up with a valid counter
argument or a practicable alternate solution. As a corporate financer, I
remember a project when a not-so-profitable fruit juice project in Karachi was
changed to an ice cream manufacturing unit as the sponsors had an established
expertise in ice cream manufacturing and selling business.

The preparation of projected financial
statements is followed by calculation of financial ratios both in line with the
SBP prudential regulations and the standard financial sector practices. While
these ratios reveal most of the financial aspects of the project, the real test
of financial viability lies in the calculation of IRR - Internal Rate of Return.
Prior to IRR calculation, such exercises are also carried out as calculation of
payback period under which the number of years the project cash flows (profit
before depreciation) will take to pay back the amount invested in the project
are determined- and the project break even point - the point when the project
operation costs will exactly equal the project profits. Although being quite
relevant, these two exercises hardly confirm the financial viability so
decisively as the IRR method does. The main objections made against the efficacy
of the payback method are (i) it ignores the timing of the cash flows; (ii) it
doesn't take into account the cash flows after the payback period; and (iii) it
ignores the time value of money. The break even analysis is perhaps more
relevant of the two as it predicts the stage when the project will start
generating net profits.

The time value of money concept is more
relevant to the present day financial management. IRR in case of project
financing is calculated on the basis of this concept. Time value concept
measures the value of future cash flows in today's rupee terms called present
value. For example Rs.100 receivable after one year has a present value of
Rs.86.96, if the going interest rate is assumed at 15 percent. Under IRR method,
all cash flows from the project ñ normally during the first 7-10 years of its
operation- are taken and checked for a discount rate that will equate them with
the total investment in the project. This discount rate is then compared against
the average weighted cost of the capital. The average weighted cost of the
capital is calculated by assuming a certain minimum rate of return to the
shareholders and taking into account the actual borrowing rate. Given that a
project is financed on the basis of 60/40 debt equity ratio, and assuming that
the minimum return to the shareholders will be 10 percent and that the bank loan
will carry a 15 percent interest rate, the average weighted cost of total
capital-equity plus debt- will come to 13 percent. For a project to be
financially viable, a minimum spread of 2-3 percent is the norm. This means that
with 13 percent average weighted cost of the capital, the project should have at
least an IRR of 15-16 percent. The higher the spread, the higher the financial
viability of the project.